Eurodollar yields and a twisted curve

Eurodollar futures trading gains and losses are derived from changes in quarterly rates at $25 per basis point, while futures on T-notes and interest rate swaps have price changes based on yield-to-maturity. The flexing of Eurodollar futures rate-to-yield curves adds to or subtracts from spreads between Eurodollar futures and swaps or T-notes.

For example, from April 11 to Oct. 10, the March 2017 (20th quarter) Eurodollar futures gained $2,375 as the quarterly rate declined by 0.95%. During the same period, five-year interest rate swap futures increased in price by $2,984 with a yield change from 1.424% to 0.8525%. During this period of declining rates and yields, the ratio of rate-to-yield at the five-year maturity increased by 0.25, reducing the price gain for the 20th-quarter Eurodollar futures relative to the increase in price for five-year interest rate swaps.

The present yield curve can be put into historical context in “U.S. Treasury rate history” (below), which shows Federal Reserve constant maturity data for three-month, one-year, five-year and 10-year rates from January 1982 to September 2013. Over the 30-year period, there are five interest rate cycles in which rates fell to bottoms that are successively lower than the previous low, including the current low rates that are presumably resting on or near the ultimate bottom.

A steep yield curve shows up clearly in the last three downtrends, and the patterns in the cycles are similar. With each steep drop in rates, the five-year and 10-year rates follow the short-term rates down, but more slowly. This creates more space between short-term and longer-term rates, increasing the slope of the U.S. Treasury yield curve. In terms of relative space between long-term and short-term rates, the current yield curve was approximately as steep as the previous two downturns before the similarity was shattered by recent quantitative easing involving the purchase of longer-term securities by the Federal Reserve.